By Mark Kerzner, President, TMG The Mortgage Group Canada Inc.
When I worked as a lender we saw a lot of Adjustable Rate Mortgages
(ARMs) - variable rate transactions. From the early-to-mid-2000s that
product seemed to be the mortgage product of choice by the brokers we
worked with.
Many brokers devised strategies to demonstrate how the ARM was more
advantageous to the homeowner than a standard fixed rate mortgage. The
"pitch" ranged from paying less interest, to having lower payments, to
aggressive principal reduction, and so on. With the benefit of
hindsight, for those consumers who chose variable rate products
throughout the last decade, they have, for the most part, come out well
ahead.
With fixed interest rates continuing to hover at historical lows (5-year
fixed rates are approximately 3.09% to 3.29% at the time of this
writing) and the small spread between discounted ARMs and fixed rates
right now, consumers are choosing fixed rate mortgages. The main
advantage for choosing a fixed rate is that payments and rates do not
change over the term of the mortgage. The most popular term is the
5-year fixed, although the 10-year fixed rate is starting to take on
some momentum of its own.
A couple of years ago the Government of Canada began changing mortgage
qualification criteria. One change was to use a benchmark interest rate
to qualify buyers for ARMs and for fixed terms less than five years. The
benchmark rate is tied closely to the bank’s posted 5-year rate, which
is currently 5.24%.
The reason for this change is that ARMs and shorter term mortgages are
vulnerable to higher interest rates when the mortgage renews. By
building in a buffer, in this case making sure clients qualify at the
higher benchmark, then at renewal, if the interest rates have increased,
there is less payment shock. It also ensures that mortgage holders
would be able to afford higher payments. That interest rate buffer now
sits at more than 2% for clients taking out ARMS for terms less than 5
years. That means if you choose to take one of those products you have
to be able to make payments on them if rates were to rise by 2%.
Once a client has decided to take a fixed term mortgage as opposed to an
ARM then the next question is what term to take. Generally speaking,
the longer the term you choose, the higher the interest rate. The rate
for a longer fixed term may be higher but it also offers greater
security against a future rise in interest rates. My advice to all
mortgage consumers today would be to set your payments as if you took
the 10- year term whether or not you select that product.
If selecting a fixed rate product is similar to purchasing interest rate
insurance, then purchase the insurance that is likely to pay you back
in the end. If the amount of “insurance” you pay during a term results
in a lower principal balance at the end of the term than that is like
being paid back at the expiry of your mortgage term.
Here is an example:
Let’s take a conventional 5-year mortgage, which is under 80%
loan-to-value, which also means there are no additional mortgage
insurance premiums. Let’s assume a mortgage amount of $250,000 amortized
over 25 years. Payments are monthly, compounded semi-annually. The
seven and 10-year terms illustrated below are examples if you were to
set your payments on your 5 year fixed term at the corresponding rates
of each of the 7 and 10 year terms. The Total Payments and Balances at
Maturity are the amounts at the end of five years.
Term Rate Monthly P&I Total Payments Balance at Maturity
5-year 3.29 $1,220.63 $73,237.80 $214,863.60
7-year 3.69 $1,273.38 $76,402.80 $211,430.47
10-year 3.89 $1,300.19 $78,011.40 $209,685.57
As illustrated above you are paying more over the life of the term but
you are also accelerating the principal repayment by an even greater
amount. More aggressive strategies would have you setting your payments
at the benchmark rate, which is the rate that the government is
suggesting all consumers should be qualified at. If you choose, and can
afford this option, you will benefit by aggressively paying down your
principal during the current term. That will create numerous options for
you down the road including;
1. Greatly reducing the amount of interest you pay over the life of your loan.
2. Significantly reducing the number of years it will take to repay your mortgage in full.
3. Providing you with options at (term) maturity. For example, you may decide to change the amortization to free up cash flow.
There is also another way to get the benefits without burdening your
cash flow-- simply choose the accelerated bi-weekly payment options.
This means you are making set payments every two weeks, which comes out
to 26 payments a year.
If cash flow permits, consider combining the 10-year payment option with
accelerated bi-weekly payments for added savings and balance reduction.
These options do require necessary cash flow and in many cases money may
be tight right now. The beauty of a fixed rate mortgage option is that
you can start this strategy at any point. If times are tight right now
you can start in a year or two.
There are so many options to consider when dealing with mortgage
products and there is an option that fits your individual need and
situation. Talk it over with your mortgage broker.
